BofA ML: Brazil is paying the price for having used the wrong policy mix in 2011

Apparently, the bank hit the nail on the head saying the government should have embraced a weaker currency long time ago. According to BofA’s research team, a looser monetary policy and tighter fiscal policy was the way to go, not the other way around like the government did. Here are some of their recent comments on the issue:

“Our analysis shows that the policy mix [in 2011] was not adequate to cope with the external shocks that the Brazilian economy faced. Weaker terms of trade and fewer capital inflows should be counterbalanced with a weaker exchange rate. Instead, the combination of tight money and somewhat loose fiscal policies kept the BRL at stronger than needed levels until recently. In turn, this strength had a negative impact on the tradable sector, whose competitiveness has deteriorated significantly in recent years. This is evident when comparing the evolution of unit labor costs with that of other LatAm countries (chart below).

In our view, the optimal policy response should have been the opposite: loose money, tight fiscal:

– Looser monetary policy would discourage capital to flow to Brazil and avoid BRL appreciation (and the costs of the sterilized FX intervention to avoid this appreciation).

– Tight fiscal policy is needed to avoid a weaker BRL to impact inflation. Fiscal spending is biased toward non-tradable goods and services, so its restriction would allow these prices to increase at a more moderate level. The policy mix has started to change more recently. The focus has been on growth, particularly reinvigorating IP and taking advantage of the drop in headline and core inflation rates (chart below).

– The Brazilian Central Bank has cut rates 350bp since August 2011, and more cuts are coming (Savings accounts changed, Selic to 7.75%). The objective seems to be to send real policy rates toward the 2% level.

– The BCB changed the FX intervention strategy and sent the BRL weaker. The ongoing decline in interest rates and the prospects for further declines have reduced BRL carry and turned the currency less attractive, helping the depreciation process.”

Below are the bank’s macro forecasts:

“… external conditions will not pull the economy up in 2012… financial conditions to improve slowly… we expect growth to accelerate: 2.8% in 2012, 4.2% in 2013… inflation at 5.3% in 2012… BRL weakness to stay.”